The Good, The Bad and The Ugly: Tim Hortons (The Good)

Jan.27.11 | About: Restaurant Brands (QSR)
I recommend Tim Hortons (THI) for purchase, as the first installment of a three-part series, “The Good, the Bad and the Ugly.”
Tim Hortons (The Good)
Why good? Tim Hortons essentially owns the coffee and baked goods market in Canada, with a more than 80% share. This share dominance gives the company tremendous pricing power at the restaurant level, as evidenced by 20 straight years of higher comparable sales.
Investment thesis
As external growth opportunities inevitably narrow, Tim’s ongoing success will become increasingly dependent on leveraging its formidable base of stores via its distribution business. Except in very rare circumstances, like in 2009 – when end demand was modest and commodity costs rose – the company has had little difficulty passing on higher prices to its franchise base.
Over the next several years, unit growth in Canada will likely slow to 2-3% (from mid-single digits historically). Still, menu prices, owing to the huge market share advantage, will rise at least at the rate of inflation. The solid same-store comparisons that result should continue to ease the way for price increases at the distribution level and distribution margin expansion.
As seen in the tables below, Tim Hortons ranks in the top quartile of the restaurants I follow for both operating margin and comparable sales.
EBIT Margin
Comparable Sales
11E
10E
09
08
07
11E
10E
09
08
07
Buffalo Wild Wings (NASDAQ:BWLD)
9.6%
9.3%
8.2%
8.4%
7.8%
1.8%
1.2%
3.1%
5.9%
6.9%
Cheesecake Factory (NASDAQ:CAKE)
8.2%
7.7%
6.3%
5.4%
7.3%
2.8%
2.0%
-2.5%
-4.0%
0.6%
Chipotle (NYSE:CMG)
16.2%
15.5%
13.4%
9.3%
10.0%
4.2%
8.6%
2.2%
5.8%
10.8%
Cracker Barrel (NASDAQ:CBRL)
7.3%
6.8%
6.0%
6.3%
7.2%
2.8%
0.8%
-1.7%
0.5%
0.7%
McDonald's (NYSE:MCD)
32.0%
31.0%
30.1%
27.4%
17.0%
4.0%
5.0%
4.5%
6.9%
6.8%
Panera (NASDAQ:PNRA)
12.8%
11.9%
10.4%
8.7%
8.4%
3.3%
8.8%
0.7%
5.8%
1.9%
Papa John's (NASDAQ:PZZA)
6.6%
6.8%
8.6%
5.8%
5.0%
-1.5%
-1.5%
-0.5%
1.7%
0.5%
P.F. Chang's (NASDAQ:PFCB)
5.2%
5.0%
5.3%
4.4%
4.9%
1.0%
0.4%
-5.4%
-3.3%
0.9%
Red Robin (NASDAQ:RRGB)
2.6%
2.3%
3.3%
5.2%
6.9%
0.0%
-1.8%
-11.1%
-1.4%
2.4%
Sonic (NASDAQ:SONC)
16.6%
13.3%
16.1%
17.9%
19.1%
-1.0%
-7.8%
-4.3%
0.9%
3.1%
Starbucks (NASDAQ:SBUX)
14.3%
13.3%
5.7%
4.9%
11.2%
5.0%
7.0%
-6.0%
-3.0%
5.0%
Tim Hortons
24.0%
23.0%
22.1%
21.8%
22.4%
3.0%
4.7%
2.9%
4.4%
6.1%
Yum Brands (NYSE:YUM)
16.3%
16.0%
14.7%
13.4%
13.0%
1.0%
0.0%
-5.0%
2.0%
0.0%
Click to enlarge
Focus on the Supply Chain
In my opinion, the most important initiatives of the CFO, with a background in the food processing industry, are to build a comprehensive supply chain and to further veritically integrate operations.
Today, more than 75% of THI's coffee is roasted internally, leaving relatively modest scope for further integration-led efficiencies within beverages. However, significant opportunities exist on the food side, which is still comparatively reliant on third parties.
The recent sale of THI’s JV stake in Maidstone Bakeries is an important step in the company’s shift toward deeper food integration. THI will continue to source certain baked products (e.g., Timbits and donuts) for several more years, as the agreement runs to 2016. Nonetheless, this transaction should push distribution sales to 62-63% of the total in 2011 (and rising from there) versus just 54% in 2006.
In late 2007, Tim’s opened a huge distribution center in Ontario, rolling out frozen and refrigerated foods to franchisees in the province, home to about 45% of its Canadian store base. Over time, there is the opportunity to expand distribution of frozen or refrigerated products, without unduly compromising product quality, as the potential for gross margin enhancement is compelling.
U.S. Operations
Given the potential of the U.S. market, the company has spent considerable time answering concerns over its U.S. restaurants, even before the recent closure of 54 units, mostly in the Northeast. After the disposal of those restaurants, which generated an estimated $750,000 in average unit volumes (ex. the 18 kiosks), accumulation unit values (AUVs) in the U.S. should rise comfortably above what I consider breakeven, at $1 million. Indeed, the U.S. should begin to steadily contribute to operating profitability, if only modestly.
Management consistently asserts its commitment to the U.S. market. But, in the unlikely absence of easing competition, that commitment is probably limited to development in and around a handful of existing, high-density northern cities.
Although Tim Hortons has had successes in certain markets (Detroit, Buffalo) the concept’s U.S. limitations are increasingly evident. Given relatively narrow name recognition and significant incumbent competition (Dunkin Donuts, Starbucks, McDonald’s) outside of Canada, THI’s U.S. strategy will likely be to leverage markets where it can gain significant scale, benefiting from distribution and advertising.
Operating Profits
With the U.S. no longer acting as a drag on operating profits, the operating margin will finish at an all-time high in 2010, at around 23%. In 2011, further sales leverage (on 4% projected comps), combined with deeper distribution penetration, should help the operating margin approach 24%.
Valuation
I value THI at $50, representing multiples of 10.5X and 20X my 2011 EBITDA and EPS estimates of $795 million and $2.50 a share, respectively. These valuations are in line with the restaurant group, as I believe that what the company lacks in relative unit growth opportunities, it easily makes up for in pricing power, consistency/earnings predictability, and margins.
Business Profile
Tim Hortons is a quick-service restaurant chain whose 3,700 stores offer a broad range of food products, specializing in coffee and baked items. Roughly 95% of its system operates under franchise agreements, including nearly all of the 3,100 Canadian restaurants and slightly less than 90% of its U.S. store base.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

>> Continue to Part II